While company valuation based upon the underlying assets of a firm can at times be reasonable (e.g. the break-up value or replacement cost), conceptually the underlying value of a company is the future cash flows that the business will generate for its owners.
As is often the case, humans regularly look for simplified ways to do a job, an example of this is the use of the price-to-earnings (PE) ratio. The PE ratio is in effect a proxy for valuing a company.
Because (in theory) a company's value should be all of its future cash flows discounted back to the present, this generally requires an assumption about earnings into perpetuity. As an aside – sometimes you could assume the company will not continue forever, in which case you would estimate the future cash flows until that end date.
Given the inherent uncertainties about the future life-cycle of many companies not being forever – consider for example the number of banks and insurance firms that "blew up" during the GFC – identifying companies that have a very high probability of longevity and the ability to at least grow earnings in line with inflation will make for the most certain estimates of future cash flow.
Here are three blue-chip stocks that have defensive businesses, meaning they should provide profits for investors into perpetuity.
1) Brambles Limited (ASX: BXB) provides a value-added service to companies which it is hard to imagine will disappear. The company also enjoys a significant scale advantage which will continue to strengthen as the company grows.
2) Woolworths Limited (ASX: WOW) provides a significant proportion of the Australian and New Zealand population with their daily grocery needs. There is little chance that consumers will stop requiring Woolworths' services anytime soon or in the distant future.
3) Ramsay Health Care Limited (ASX: RHC) provides essential healthcare services to patients at its hospitals around the world. Unfortunate as it may be, it's hard to imagine a time when people won't require these vital services.
Foolish takeaway
With many market participants being active traders who focus on price rather than value, investors who focus on value – which is rarely as volatile as the price movements in a share would suggest – stand a good chance of earning above average returns.
